When executives take the discussion seriously and use it as an occasion for a tough-minded assessment of their business, the exercise tends to put a much sharper lens on the strategic choices and operational priorities they face in order to deliver and sustain above-average TSR in the future.
The problem, however, was that the CEO doubted the company could sustain this TSR profile into the future. The improvements in gross margins that had been the primary engine behind the company’s recent perfor- mance had pretty much run their course; executives esti- mated that the rate of improvement in margins would decline from 8 percent to as little as 2 percent per year—
leaving a TSR gap of 6 percent. If the com- pany couldn’t somehow fill that gap, its fu- ture TSR would drop from 15 percent to 9 percent. Typically, we find that it is the rare com- pany that can occupy the same “cell” of the TSR sustainability matrix for extend- ed periods of time. Rather, sustainable val- ue creation requires knowing when and how to shi one’s TSR profile from one cell to another. Sustainable value creation requires knowing when to shift one’s TSR profile. Additional revenue growth from tradition- al sources was unlikely to fill the gap. Fu- ture organic growth in the business could be stretched from 4 percent to, perhaps, 5 percent, but that gain would likely be neutralized by the fact that future opportunities for acquisitions that fit the company’s current business strategy were limited. At most, they would deliver only another percentage point of revenue growth per year, rather than the 2 percent of the recent past. Aer all, a company’s core markets will eventually mature. Opportunities for strategic M&A will dwindle or become too expensive. The low-hanging fruit in terms of cost reduction and margin improvement will have already been picked. A high average ROE will de- cline as new growth opportunities become less profitable than previous investments. The more successful the com- pany at delivering above-average TSR, the more investors will bid up its valuation multiple, thereby making it more difficult for the company to deliver above-average TSR in the future. Executives have to carefully assess how all these factors are likely to affect their TSR performance over the next three, five, and ten years. Three factors, however, somewhat ameliorated the com- pany’s situation. First, like most companies, this compa- ny’s share price experienced a major decline in late 2008, but the decline—about 25 percent—was significantly less than that of its main competitors. By mid-2009, the com- pany’s share price had largely recovered the ground it had lost; however, because the equivalent share price was on a much larger base of total earnings, its P/E multiple dropped from the low twenties to about 16. The lower P/E multiple had the effect of shiing the company’s TSR profile one cell to the le in the lower row of the 15 per- cent TSR matrix, increasing the yield of its net-income payouts and decreasing the size of its TSR gap, although not by much. For example, we have recently been working with a com- pany that for a number of years had a TSR profile rough- ly equivalent to the cell in the lower right-hand corner of the 15 percent TSR matrix in Exhibit 5. The company had been pursuing a version of a cash-machine strategy. Its or- ganic revenue growth rate was a relatively modest 4 per- cent, which it had been able to supplement by about 2 percent per year through acquisitions (although at a cost that required the company to take on considerable debt— despite its ROE of 20 percent). But the main driver of its TSR performance was a steady improvement in gross margins, which had increased from about 35 percent to 45 percent over the previous five years and had fueled an ad- ditional 8 percent annual growth in the company’s net in- come. With an overall growth in net income of 14 percent per year, a P/E multiple that had remained steadily in the low twenties, and a regular program of share repurchases that paid out 20 percent of net income every year (equiva- lent to a cash yield of 1 percent), the company had regu- larly delivered against its TSR target of 15 percent. Second, the fact that the company had few options for M&A had a silver lining. Although the company’s past ac- quisitions had added to net income, they had been quite expensive compared with investments in organic growth. In fact, they had stretched the company’s debt-to-capital ratio to uncomfortable levels. Doing fewer deals in the fu- ture would free up cash that could be used to significant- ly raise the company’s net-income payout ratio—from 20 percent to as much as 45 percent—essentially moving the company to the middle cell of the 15 percent TSR matrix. This would have the effect of tripling the company’s cash